real estate investing

All posts tagged real estate investing

Every few months, someone wants to know if its a good time to buy real estate. A reader asked an interesting question:

Interest rates are artificially low and we won’t see rates this low for a long, long time. What are your thoughts on buying vs renting for a first timer? In my gut I know that housing is still overvalued, but should I jump on low rates and lock in a fixed payment knowing that future inflation will make this payment even smaller?

Most people do not pay cash for their homes, they get a mortgage. And the monthly payment they can afford, along with the current interest rate determines how large a mortgage they can qualify for.

Lets do some back-of-the-envelope calculations. If you can qualify for $2,000 a month (lets  ignore principle, taxes and insurance for now) and rates are 5%, you’ll qualify for approximately $480,000 worth of mortgage. If rates rise to 6%, you only qualify for $400,000 worth of mortgage.

Did you see how a 20% rise in interest rates caused a 17% decline in the amount of mortgage you would able to qualify for?

If your income isn’t going to increase 20% over the next 2 years, but rates might rise 20%, less people will be able to afford homes. So the pool of available buyers for our $480,000 house has become a lot smaller and demand drops off. According to economic principles, as the demand decreases, prices should decrease as well. Thus, the price should drop to $400,000 to match the purchasing power of buyers.

Additionally,  the banks have unsold inventory sitting on their books – in many cases they haven’t even foreclosed on people who stopped making their payments a year ago.

So we have a scenario where the number of homes on the market is likely to increase or stay flat, interest rates are going to increase, and incomes aren’t going anywhere.

The only reasons you should be buying a house right now are

  1. You’re starting a family, don’t want the hassle of moving and can afford a reasonably large house which you will live in for several years
  2. You can afford to pay cash and don’t care where the market is going
  3. You have specialized knowledge of the markets and can get a much better deal than your local home buyer. Real estate investors will be able to take advantage of the current environment to buy cheap homes that generate positive cashflow.
  4. You have a stable job, expect to be in the same place for several years and don’t want your landlord telling you that you can’t paint the living room bright pink

In short, don’t be mesmerized by the tales of real estate agents and Realtors telling you that interest rates will go up and price you out of the market. Only a booming economy with people falling over themselves to buy houses can do that. It may seem like people are out buying homes, but its a temporary phenomena created by all the government to stimulate the housing market. When this stimulus ends, homes prices will probably drift down by the same amount. On a similar note, ZeroHedge has a good article on how dropping homes prices are inversely correlated with rental rates, something I have not been able to verify with my properties!

Only buy a house if you have a good reason to buy one. Don’t get suckered in to it.

At some point we will see inflation, but it’s next to impossible to figure out when.

Over the past few weeks, several of friends have asked me if its a good time to buy a house now that real estate prices have bottomed. Encouraged by the media, everyone seems to think that home prices have bottomed out and the recovery is about to begin.

Even Jim Cramer jumped on the housing recovery bandwagon and declared that June 30th would be the bottom! As I mentioned before in Are Jim Cramer’s picks worthless?, you shouldn’t be taking your investment advice from him. I don’t know what sort of crystal ball he has, but his track record isn’t very good. Besides, people who can predict the future (like David Einhorn) tend to invest for themselves and not make broad public statements.

Home prices may be fairly valued, but whenever you have a bubble of huge proportions, valuations do not simply revert to the mean, they overshoot it and become grossly undervalued.

A lot of people have been reporting that housing is rebounding. Here’s an excerpt from Reality Times dated June 9th.

The big economic news for housing this week is all about sales.

Housing sales and pending sales contracts are up, dramatically in some markets, and a rebounding real estate sector could soon start stimulating the broader economy.

Even Federal Reserve Chairman Ben Bernanke told Congress last week that essentially the worst is over, the housing market is stabilizing, and we’re heading out of recession in the second half of the year.

In a handful of major markets, closed sales also are moving up sharply. In Las Vegas, sales jumped by 36 percent during April – the highest in two years, according to MDA DataQuick researchers.

Meanwhile, low prices nationwide, combined with mortgage rates at near-record lows, have pushed the National Association of Realtors’ Affordability Index into record territory.

But here’s a little sobering news: It’s becoming increasingly clear that low mortgage rates are not going to be around forever. Average thirty year fixed rates took their biggest jump in half a year last week on bond market jitters.

With everyone and their real estate agent being confident about the housing rebound, I can see how its easy to get sucked into the belief. Let’s go through the points step by step.

The Fed Chairman didn’t know that we were in recession until almost a year into it. On the other hand, some people did get it right. He also didn’t know that lowering the interest rates below the real rate of inflation would cause a spike in asset prices creating the largest bubble in history (to be fair, it was a different Fed Chairman).  Given the poor track record, why should we believe him now? Part of his job is to maintain the world’s faith in the US dollar (and by extension the US economy) and another part is maintaining consumer confidence in the US economy. By being bullish on the economy, he’s only doing his job! Since he always needs to project a bullish facade, he isn’t a reliable source of bullish information.

Home sales have jumped in many markets. However, by itself the number of sales is not an indication of a housing bottom. Basic economic principle dictates that when prices fall, demand increases. At a certain price, there will be a strong demand for housing. The question to ask is whether houses can be built (or rented out) profitably at this price.

There is also some evidence that the median home prices are increasing in some areas as well. However, there is no median home size information included with this data.  If more large homes are being sold, the average home price will increase. You can read a more detailed explanation at Minyanville, but here’s the gist of it:

And as price discovery works its way through well-to-do areas, the mix of homes sold will continue to revert to more expensive sales, pushing up median- and average-sales-price data. This dynamic will present the misleading conclusion that the country’s housing market is recovering, even as actual prices continue to fall.

On top of that, the unemployment rate keeps increasing every month. Yes, the second derivative is positive which means the rate of job loss is slowing, but it’s still a negative number! Read this article at FiveThirtyEight about why a decrease in the rate of job loss is nothing to celebrate.  Additionally, its becoming more difficult to obtain a home mortgage. This two reasons alone are causing the pool of potential home buyers to shrink, which results in a lack of demand.

The few people I know who are buying foreclosures or REOs at 40% discounts to current market price are paying CASH for investment homes. But how many people have $150,000 lying around? The savings rate in the US was ZERO for many years. In the past year it’s increased to about 8%, but that only leads to lower consumption, a lower GDP and in turn more layoffs. And as investors pay $150,000 for homes listed at $250,000, this exerts a further downward pressure on prices.

So when is a good time to buy?

When the media stops reporting about the recovery and starts telling you that real estate is a lousy investment, that’s probably a good time to start buying.

Right now, I think people are still too bullish.  However, that being said, if you can afford to pay cash or can find a really cheap house or even a manufactured house that rents for twice the mortgage payment, it would probably make a good investment. But on the whole, I would wait.